From the March 2014 issue of Futures Magazine • Subscribe!

Buy and Hedge

Buy and Hedge: The 5 Iron Rules forInvesting Over the Long Run
By Jay Pestrichelli and Wayne Ferbert
FT Press
$29.99; 289 pages

This book focuses on using options as hedge for a portfolio, yet no where on the book’s jacket or flaps or in the five quotes praising the book is the word “option” mentioned, yet there are eight chapters out of 29 and over 125 pages devoted to the subject.  That is strange.

The authors’ five iron rules clearly explained in the book are:

  • Hedge every investment
  • Know your risk parameters
  • Use diversification and invest for the long-term
  • Be your own investment guru
  • Harvest your gains and losses

By hedged the authors mean crafting a defensive portfolio that limits downside losses in violent and volatile markets.  Hedging equals using options, according the authors, and it allows an investor to limit their downside.

Options let an investor control many shares at a significantly lower cost, as well as define risk levels with a high degree of certainty (e.g., married put).  Options can also be sold for income to help fund the cost of hedges (e.g., collars).   They suggest using tax harvesting when appropriate, which properly offsets gains against losses.

The authors recommend three option tactics: married puts and calls; collars and in-the-money options. They also recommend two advanced tactics which are vertical and diagonal spreads. They suggest hedging the entire portfolio instead of each position. Additionally, they suggest it is important to determine the correlation of each portfolio position to the market and then use six- 12-, and 36-month correlation measurements to help in selecting the most appropriate options. Typically, the higher the correlation of the position to its benchmark, the less the diversification.

According to the authors, combining three strategies: indexing, asset allocation and defensive hedging, provides excellent long-term benefits. Pestrichelli and Ferbert believe that their strategy teaches investors how to modify and control risk.  Furthermore, they put forth the view that long-term investing (one to three years or more) is their approach and that it is much preferred to short-term investing. They feel that approach is much less time consuming to manage while providing time for the hedge to perform better. New investments should be held for at least one year and most investment should be held for at least two years or more. And individuals should never invest for a period of six months or less.

They recommend that each investor determine which investments they are good at making and then find the right hedge for those investments. Moreover, investors should make sure that each investment has derivatives (options, futures and index options).  According to a 2010 TD Ameritrade study, the best investors use stop loss orders, stop limit orders or options. The authors believe that building in portfolio protection makes individuals better investors in the long run. Volatility needs to be understood by investors, as it erodes investment returns in several ways: mathematically, psychologically, and logistically.

Pestrichelli and Ferbert suggest investors use ETFs instead of stocks with options bought on them. They have a website www.buyandhedge.com that contains useful pages to track investments and option positions. They recommend keeping 50% of the portfolio in broad market indexes and not concentrating more than 10% of the portfolio in one sector.  

The authors also recommend building a cost effective hedge using options and sector ETFs as a pseudo hedge. They also advocate deep in-the-money calls at least six months out. This approach is best used as a stock replacement strategy rather than a hedge or speculative play.

In summary this is a basic primer on using put and call options as defensive hedges. The writing is crisp and clear. Unfortunately, no bibliography is provided for the further study of ETFs or options. Overall the book provides investors with a sound investing approach in today’s uncertain markets.

Leslie N. Masonson is a trader and the author of Buy Don’t Hold and All About Market Timing. Reach him at lesmasonson@yahoo.com

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